UK banks' ECL scenarios vary

Projected economic outcomes most widely dispersed at Barclays

The big four UK high street banks use very different economic scenarios to estimate the amount of cash they need to set aside to cover loan defaults.

Lenders employ an array of forward-looking simulations to size expected credit loss (ECL) provisions under IFRS 9 accounting. These are unique to each bank, meaning the number of, and economic assumptions featured in, these scenarios vary.

Barclays uses five scenarios, Lloyds four, HSBC six and RBS five. Each bank uses one baseline scenario they assign a high probability of occurring and a series of outlier scenarios, each with a low likelihood of coming to pass, as inputs to their ECL estimates. 

The assumptions generated by Barclays' scenarios are most widely dispersed of the group, with average UK GDP growth assumptions ranging from –4.1% in one downside scenario to 4.5% in one upside forecast, and assigned probabilities between 3% and 41%. 

In contrast, RBS's scenario assumptions are more tightly clustered, with projected GDP growth ranging from 1.1% to 2.6% and probabilities between 12.8% and 30%.

Two of HSBC's alternative downside scenarios for the UK have low assigned probabilities of 5%, but severe GDP growth assumptions of –0.7% and –0.1%.

Lloyds did not disclose GDP assumptions for its scenarios, but projected unemployment rates in its forecasts range between 3.9% to 6.9% with probabilities between 10% and 30%.

ECL provisions at end-2018 were £6.8 billion ($8.9 billion) each at Barclays and HSBC and £3.4 billion each at Lloyds and RBS. 

What is it?

Under IFRS 9, banks' ECL provisions are calculated using forward-looking scenarios for GDP growth, unemployment, inflation and short-term interest rates, among other economic indicators.

Each scenario uses assumptions that are set using a standardised framework, supplemented with the independent judgement of the bank's managers. A central, or baseline, scenario, reflecting the most likely path the economy will take, is assigned a high probability of occurring and therefore has the most influence over the size of ECL provisions.

Less probable, but more extreme, scenarios have a lesser role in shaping overall provisions. Banks have discretion over the number and severity of scenarios used to generate their ECL provisions.

Why it matters

The switch to the ECL model under IFRS 9, and its reliance on forward-looking scenarios, makes loan-loss provisions more volatile between periods than under the old IAS 39 standard. The discretion handed banks to devise their own scenarios, and select the number used to generate ECL provisions, also means the prudent ratio of loan-loss allowances to net exposures can vary between banks.

With a disorderly Brexit looming, banks have to hope their downside scenarios are appropriately calibrated to capture the possible economic aftershocks, as otherwise actual loan-losses could exceed provisions and eat into their capital instead. HSBC took the exceptional step of introducing a trio of alternative downside scenarios to cover a range of Brexit eventualities at end-2018, but wasn't followed down this road by any of its peers. Lloyds, for instance, stated that its range of expected economic outcomes adequately captured a range of post-Brexit outcomes. 

We'll find out later this year, when the economic consequences of leaving the European Union make themselves felt, which lender was too conservative, and which too optimistic, with their assumptions. 

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